Asia: where we stand
Article | 28 April 2017
The prospect of improving corporate earnings has helped drive the recent strong performance of Asian equity markets. While there are reasons for concern as well as optimism, we believe that there are attractive opportunities in Asia for disciplined, active fund managers.
Asian equity markets have enjoyed a strong start to the year, but looking back as far as 2010 shows that returns have lagged those of developed markets. The main reason for such poor relative performance is that expectations of Asian corporate earnings have consistently been too optimistic. Year after year, analysts’ initial expectations have had to be downgraded and the absolute level of earnings growth has been low by historical standards.
This is largely due to the fact that Asia’s earnings growth prospects are still highly dependent on exports growth, which has been anaemic in recent years. Against this backdrop, the aggregate valuation of Asian companies in terms of price/book value has fallen to levels close to the bottom of its long-term range. However, that derating has coincided with a decline in aggregate return-on-equity, or overall profitability. Nevertheless, we feel that Asian equity markets are trading at too big a discount to their developed market peers as it does not seem that the political or economic risks are substantially higher.
Reasons for optimism
One catalyst that could see this valuation discount narrow would be a sustained improvement in Asian exports. The current cyclical upturn in both developed and emerging markets has seen an improvement in exports growth both in commodity-dependent economies such as Indonesia, as well as manufacturing-orientated economies such as Taiwan and South Korea (see Figure 1).
Source: Datastream, as at 31 January 2017.Exports growth is a three-month moving average shown year-on-year.
We have also seen earnings revisions turn positive across the region. However, if markets are to sustain their recent progress, analysts’ earnings growth estimates for 2017 of around 15% may need to be sustained. Achieving this is not out of the question, in our view, given the low base in 2016, but the potential for this year’s political agenda to lead to significant disruption is obviously a risk.
Reasons for concern
In the near term, the biggest risk would appear to be a shift in US trade policy under President Donald Trump. The imposition of a general border tax adjustment by the US, or even a tariff on a specific sector, such as steel, would be bad news for the Asian region. However, while we remain cautious, we expect that the President’s protectionist rhetoric will probably be diluted by the necessity for pragmatism.
The other major concern is the rapid build-up of debt in China, which we believe is not sustainable and needs to be monitored closely. We do not feel that there is an impending financial crisis, but China’s corporate debt overhang will need to be addressed eventually. There is some comfort in the fact that China continues to have huge foreign exchange reserves totalling around US$3 trillion.1 While these have been reduced over the last year or so, levels do appear to have stabilised. The banking system also remains liquid and well-funded, and while loan-to-deposit ratios have deteriorated over the last year or two, they are still relatively low. Other forms of credit, such as off-balance sheet financing, have gained in popularity (as can be seen in Figure 2); but China’s authorities have gradually and quietly tightened capital controls, making it difficult to believe that the situation could escalate suddenly. In the meantime, until there is genuine reform, the industrial sectors are unlikely to see durable improvements in capital allocation and earnings, which explains our limited exposure to this area of the market.
Despite the challenging macroeconomic backdrop we believe there are attractive opportunities for investors who take a disciplined active approach. As such, we remain focused on fundamentals, seeking to invest in companies whose share prices are substantially below our estimate of fair value, and, particularly in my case, those that have an ability to grow or maintain their dividend payments.
Source: Emerging Advisors Group to 30 November 2016 (latest available)
1Source: Bloomberg, as at 3 April 2017. 2 Adjusted using private credit from the banking system.
Where Tim Dickson has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.